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Invest for income and reap dividends

Equity Isas can generate a tidy tax-free sum. They must be good if the chancellor’s taking notice

If you are hacked off with paltry cash returns, and don’t mind taking some extra risk, equity investments can offer excellent income yields in the form of dividends.

Only 31 of 738 cash savings accounts on offer pay more than the rate of inflation in January (1.8%), according to the financial data provider Moneyfacts. Few cash Isas pay 1.8% – the average one-year rate is 0.86%, while the average no-notice rate is 0.64%.

Savers, therefore, run the risk of their savings losing value. Martin Bamford of adviser Informed Choice said: “Low interest rates and rising price inflation — the current conditions — make cash a risky option in terms of buying power, as savers will see that eroded in real terms over time.”

In contrast, some equity-based funds designed to produce income are generating about 5% a year. Holding such funds in a stocks and shares Isa means dividend income and capital gains roll up tax-free and do not have to be declared on your annual self-assessment tax return.

Daniel Addison, a financial planner with independent financial adviser NW Brown in Norwich, pointed out that despite the potential for much higher income, stock market-based funds will not suit everyone. “Although historically stock markets have risen over time, they are volatile and the value of any investment will rise and fall,” he said. “That is why each individual’s attitude to risk is paramount in any decision about how to invest their savings. If the thought that your investment might at times go down in value keeps you awake at night, then equities are not for you.”

You should also consider how long you can keep your money invested. Those who are likely to need access to their capital in the short term, rather than just drawing any income generated, could be forced to withdraw money when markets are low. Addison said: “The longer an investment is held, the more it can ride out the market’s peaks and troughs.”

Mark Dampier, investment expert at the financial adviser Hargreaves Lansdown in Bristol, was so concerned about the risk that low interest rates posed to his 91-year-old mother’s income stream that he invested a large proportion of her money in equity-based funds. After suffering an illness, Christine Dampier realised she could no longer live alone some 130 miles away from her two sons, so decided to sell her home in the London suburbs to buy a bungalow in a retirement village in Taunton, Somerset.

She had about £400,000 left over after buying the bungalow, and as her only source of income was the state pension, she needed that capital to generate enough income to cover her monthly costs of £1,000. Dampier said: “If the full £400,000 were invested in cash deposits, it would earn interest of about 1%, producing just £4,000 a year — nowhere near enough to cover her costs. And if she spent the capital itself and her living costs increase, it might not last long enough to meet her needs. Her mother’s sister lived to the age of 103.”

Instead of investing in cash deposits, Dampier spent £50,000 of his mother’s money on an annuity. “Because of her age that produces a surprisingly high amount of income — £10,000 a year,” he said. He invested a further £125,000 in a selection of equity funds producing income of about 4.5%, or about£5,625 in a full year.

Investors can currently earn up to £5,000 in dividends or income from equity-based funds free of tax, but chancellor Philip Hammond announced at the budget that this would fall to £2,000 from April 2018. Therefore, it is still worth using your Isa allowance to shelter income-generating funds. Dampier said: “It costs no extra to take out an Isa, and who knows when the tax regime may change again?

“My mum has used her full Isa allowance this year and will do the same next year.”

Dampier recommended that investors who are older and reliant on receiving a regular income should opt for funds that generate a consistent level of income, such as JO Hambro UK Equity Income, with a yield of 4.3% over the past year, or Artemis Income, which has yielded 4.05%.

Those who are still approaching retirement and can afford to earn a more variable income in exchange for the potential of greater capital growth might prefer the CF Woodford Equity Income fund, which yielded 3.4% last year.

An investment portfolio designed to produce income typically also includes corporate bonds and gilts — debts issued by companies and the UK government, which pay a regular “coupon” or interest. The high demand for these types of investments has driven up their price, resulting in a lower yield, and investment experts have long speculated that the market is experiencing a “bond bubble” that is likely to burst when interest rates eventually start rising again.

Bamford said: “For income-seeking investors, gilts and investment grade corporate bonds have limited appeal in the current environment due to their very low yields.

“But within a well-diversified investment portfolio, corporate bonds and gilts continue to play an important role; they are negatively correlated with equities, so help to smooth out the volatility associated with the stock markets.

“When interest rates go up, it will reduce the capital value of bonds, but talk of a ‘bond bubble’ has been overstated.”

Bamford recommended the Fidelity Extra Income fund, a bond fund which has a 3.9% historic yield and strong performance over the longer term.

Our table, below, shows the top five equity income funds, according to their performance over the five years up until the end of last week.

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